If you must deal with burdensome debt or a financial crisis, a reserve of ready cash may seem like the perfect solution. In fact, financial experts suggest that you set aside three to three-to-six month’s income as an emergency fund, or you may be tempted to tap your retirement account for cash to cover an unforeseen need. Cashing out early is a bad idea unless it is the only way to avoid a bankruptcy or foreclosure.

Eric Severeno said “Filing for bankruptcy may allow you to keep your home or to at least help you get back on your feet financially,” but “it will have some impact on your long-term credit score and on your ability to buy a home again in the future.” You will be sacrificing long-term financial security for the sake of short-term relief.

· Why People Cash Out Retirement Accounts

When someone withdraws money early from a 401(k) or IRA, he usually does so for one of three reasons. First, he may want to pay off a student loan or another large debt. Second, he may be facing a financial crisis. For example, he might have incurred unexpected medical bills. Finally, some people think that they have to cash out a 401(k) if they change employers. This is incorrect. You may roll the retirement account balance over to a traditional IRA or to a 401(k)-plan offered by your new employer. This is called a Direct Transfer Rollover and you need to make triple sure that this is what you’re doing, or taxes and penalties will be due. There are no penalties or tax consequences for doing a rollover of this kind. I can’t stress that enough: make sure your 401(k) provider knows to do a Direct Transfer Rollover!

Alternatively, you can roll any pre-tax retirement savings into a ROTH IRA, which I definitely recommend you do, as long as you can pay the taxes that come due. ROTH means post-tax, which means you pay the taxes on the initial investment, and then the growth is tax-free. This is important because, if you’re starting retirement early (which we should all do), something like 90% of your retirement savings are going to be growth, not your initial investment. And whether you’re in a ROTH or a traditional, you need to make sure your securities inside of them are selected by an expert.

· The Cost of Cashing Out

When you take money from a retirement account before you reach age 59 1/2, the withdrawn funds are usually subject to income taxes and a 10 percent penalty tax. Suppose your marginal tax rate is 25 percent. If you withdraw $10,000, the federal income tax comes to $2,500. You will incur a $1,000 penalty as well, which leaves you with only $6,500. In addition, you lose the future earnings the money you take out would have produced. Let’s say that your retirement account averages a 5 percent annual return. If you leave the $10,000 in the account, it will grow to more than $40,000 after 30 years.

· Alternatives to Early Withdrawal

Noted financial adviser Dave Ramsey says that using retirement account funds to pay off debt is poor strategy. You will be better off in the long run if you go on a tight budget until you pay off what you owe. Explore alternatives before cashing out your retirement account. You may be able to negotiate reduced payments with creditors. Sell something. Take a second job. Bend over backwards not to cash out a retirement vehicle early. I want you to get out of debt, and I want you to survive a financial emergency, but I don’t want you to be penalized at 35+ percent in order to do it.

· Conclusion

Withdrawing money early from a retirement account can make sense to avoid a bankruptcy or foreclosure. In either case, the cost and long-term damage to your credit may mean cashing out is a better choice. Ask for advice from a financial expert or CPA before taking any drastic measures.